Abstract. The issues raised by VAT and financial investments may be the most challenging of all VAT and financial supplies to resolve. In a model VAT, there ...
Taxation Law and Policy Working Group School of Law Working paper: 17/01/29
This working paper has been published as: Richard Krever, ‘VAT and Financial Investments’, chapter 12 in R. van Brederode and R. Krever (eds.), VAT and Financial Services: Comparative Law and Economic Perspectives (Springer, 2017) 189-197.
VAT and Financial Investments Richard Krever
The University of Western Australia M000, Perth WA 6009 Australia
CRICOS Provider Code 00126G
VAT and Financial Investments Richard Krever
Abstract The issues raised by VAT and financial investments may be the most challenging of all VAT and financial supplies to resolve. In a model VAT, there would be full recovery of all VAT associated with savings and investment. Three problems make it difficult to achieve this aim in respect of individuals’ investments. The first is that of expenses related to the acquisition of investments that may also be characterized as personal consumption expenses. The second is the fact that most savers are not registered for VAT purposes and it would be impossible to bring them all into the VAT net to refund input VAT related to savings. The third is the political implications of increasing the regressivity of the VAT by returning input VAT to savers. This chapter explores options to address these issues. It then considers the problem of VAT and company investments such as the VAT consequences when operating companies are owned by holding companies. Legislative options to address this issue are reviewed.
12.1
Introduction
Of all the issues raised by the actual or theoretical application of VAT to financial supplies, the most persisting and confounding is the application of VAT to financial investments. Modern VATs have confronted and successfully addressed perceived difficulties that once kept insurance supplies and gambling supplies out of the VAT base and extension of the tax to these supplies has not proved difficult. The extension of the VAT to loan intermediary supplies has proved more difficult but limited regimes such as zero-rated business-to-business supplies, additive method taxation at the supplier level, or reduced input tax credits to avoid vertical integration biases have ameliorated many negative aspects of traditional VAT exemption for these supplies and a number of proposals for reform have been developed. The one issue remaining to be addressed in whole or in part by action or,
indeed, under any plan for reform is the impact of the VAT on financial investments. The complexity of VAT reform of any sort in a 28 nation community helps explain why the home of the traditional European VAT has yet to tackle reform of VAT and financial supplies generally, let alone VAT and intangible financial investments. But modern VAT jurisdictions have solved the practical questions and reformed many other aspects of the application of VAT to financial supplies such as intermediary insurance services and intermediary gambling services. Many have similarly adopted comprehensive systems for applying the VAT to tangible investments, most notably immovable property. What holds back reform in this last area? Practical, conceptual and fiscal issues may explain why so little attention has been paid to this question. This chapter explores those issues.
12.2
Acquiring and Issuing Investments
In form, the VAT is a tax imposed on supplies of goods and services with legal liability falling on the supplier. Where it is inconvenient to collect from the supplier, liability may be transferred to the person acquiring a supply through a reverse charge rule. In substance, however, it is presumed that ultimately the customer remitting a VAT-inclusive price bears the economic cost of the tax. The tax that notionally falls on suppliers is thus intended to be a tax on final consumption, with input tax credits for business-to-business transactions used to take intermediary supplies along the commercial chain to final consumption out of the tax base. Consumption is the application of income or withdrawals from savings for personal benefit.1 Applying income to acquire investments or reinvesting proceeds of disposal of investments in replacement investments clearly falls outside the notion of consumption. Amounts applied in this way by individuals, collective investment vehicles or businesses should equally clearly be outside the base of a VAT intended to act as a consumption tax. There is, similarly, no consumption element to ancillary expenses—legal costs, accounting fees, filing fees, transfer fees, valuation costs, advice costs—incurred only for the purpose of acquiring investments and thus forming indirectly part of the cost base of the savings. Nor is there any consumption element to the cost of maintaining or holding investments. In the case of an enterprise doing nothing more than holding investments—a holding company, for example—ancillary expenses related to savings may include rent, some salaries, office supplies and utilities, etc. The logic of recognizing expenses ancillary to the acquisition and holding of investments as costs of savings rather than personal consumption expenditures
1 Extrapolating from Henry Simons’ classic definition of income, as income = consumption plus net increases in savings. See Simons (1938, p. 50).
applies equally to enterprises that incur expenses to receive the proceeds of another person’s investment either as equity in, or loan capital to, the enterprises. Costs incurred by an enterprise attracting investment capital in the form of equity include brokerage fees, legal and accounting expenses, filing fees, advisor fees and valuation fees. Borrowings acquired directly from lenders by way of businessissued bonds involve a range of expenses paid to third parties, particularly legal and accounting fees, as well as brokerage and distribution expenses and valuation and advisor fees. Many of these expenses will be incurred, too, in respect of loan funds sourced from a debt intermediary enterprise such as a bank. Loans from this source also incur intermediary fees imposed indirectly through the interest charged on the loan. None of these ancillary expenses relating to the acquisition of share or loan capital for use in a business involves a personal consumption element and a benchmark VAT would accordingly provide a mechanism for recovery of any tax borne on the acquisitions.
12.3
Investments by Unregistered Individuals
Recognizing the non-personal character of expenses directly related to the acquisition of financial investments is straightforward. Direct investment acquisition costs clearly sit at the non-personal side of a spectrum of expenses that has purely investment or business outgoings at one end of the spectrum and personal consumption expenditures at the other. The same cannot always be said of ancillary expenses related to the acquisition of investments, particularly in the case of expenditures by individuals saving outside the scope of an enterprise. An example of an ambiguous expense is the acquisition of generic investment information such as a subscription to a financial journal or newspaper. While the notional purpose of the outgoing may be to acquire information relevant to particular or general investment options, there is an ancillary acquisition of generic knowledge of personal benefit to the subscriber. In many cases, it is quite probable that this other benefit is of greater and more lasting value than information on particular potential investments. The amount paid for services related to investments might also include possible personal consumption elements. The investor seeking to acquire shares could make the purchase online for a small cost or use a broker who provides personal service for a much greater cost. The higher cost may reflect additional investment services —advice or analysis—or may reflect a personal preference for social interaction. Similar commercial-personal borderline issues arise elsewhere in the tax system, particularly the income tax: education expenses that are related to the derivation of income also provide personal life enrichment benefits, commuting expenses related to employment are incurred because of personal preference for residential premises location, and meal and entertainment expenses that are ostensibly tied to income generation substitute for personal consumption expenses. In some cases, the borderline issues have been resolved by the courts applying judicial doctrines and in
others the legislature has intervened to develop statutory guidelines to address the issues. Legislative solutions usually establish bright lines to demarcate expenses that can be deducted for income tax purposes or that are creditable for VAT purposes. In some cases, they simply cap the proportion or amount that can be recognized as commercial (non-consumption) expenses. In cases where the personal element of an expenditure significantly outweighs the commercial benefit of the outlay, the legislative rule may deny income tax deduction or VAT input tax credits entirely. Analogous statutory rules might be needed if VAT regimes were reformed to allow recognition of input VAT incurred on expenses that are ancillary to the acquisition of investment or savings. Three challenges must be faced if VAT systems are to be reformed with the goal of providing recognition for input tax on investments and savings. The first, already noted, is that of distinguishing investment expenses from personal consumption outgoings. The second, and on its face greater, challenge is devising a mechanism for recognition of input tax credits for individuals who are not registered for VAT purposes and whose investment and savings activities are conducted outside the capacity of an enterprise. If the conventional VAT approach to input tax relief— registration and refundable input tax credits—were adopted, the definition of enterprise or business would be expanded to include savings and investment and individuals would be allowed to voluntarily register as VAT taxpayers, regularly claiming refundable input tax credits for ancillary costs associated with their investments. Wholesale registration of this sort is clearly not feasible, however—it would be impossible for the VAT system to cope with mass registrations and processing of vast numbers of additional returns and refunds. One possibility is to use the income tax system as a mechanism for delivering input tax credits, allowing investors to utilize refundable VAT input tax credits against their income tax liability. As investments and savings are held primarily by higher income persons, entitlement to refundable input tax credits will accrue primarily to persons already filing returns that will in turn be processed by income tax officials familiar with assessing and auditing various claims for credits against income tax liability. It is unlikely that lower income persons who fall below the income tax filing threshold have savings or investments that involve input tax. The primary investment of lowest income persons may be bank accounts and, for the present at least, no jurisdiction has found a way to measure input tax associated with a bank’s intermediary services and allocate the tax to individual depositors. The third, and possibly intractable, challenge is a political challenge. Whatever the theoretical merits of reform to remove input tax from savings and investments of individuals and however simple it might be to implement reforms in practice via the income tax system, political economy considerations probably rule out any prospect for change in the foreseeable future. To begin with, reform would be costly— recognizing savings and investment as business activities would generate no positive VAT revenue but would lead to a reduction in income tax revenue. At the same time, it is not clear that there will be any offsetting efficiency gains yielding economic growth. By removing the cascading burden on active businesses
of predecessor turnover taxes, the VAT paved the way for vertically integrated firms to shift to acquisitions from more efficient specialist enterprises, raising overall productivity and economic growth. There is no reason to suspect a similar growth dividend would follow from allowance of input tax credits on individuals’ investments and savings. Input costs are incurred regularly by ongoing businesses and the costs, including input tax components, form a not insignificant part of business activities. Removing input tax credits on acquisitions from external businesses prompted almost immediate behavioural responses. In contrast, input tax on expenses ancillary to investments are incurred infrequently and are relatively insignificant in terms of the total amounts involved. The tax is unlikely to have an important impact on the level of savings and investment or the form it takes; the effect of removing the tax may be slight. Finally, however sound it may be from a theoretical perspective to remove VAT from investments, any change that lowered the VAT liability of higher income persons with little impact on lower income persons would likely reignite concerns over the regressivity of VAT in general. Imposing VAT on savings may well be inconsistent with the theory of a consumption tax but it is entirely consistent with the underlying principle of income tax—income is the measurement of ability to pay and the application of tax to consumption or savings is irrelevant to income tax liability. Viewed from the perspective of an income tax, the non-taxation of savings under a consumption tax is regarded as a concession.2 Politicians seeking to protect or expand the indirect tax base are unlikely to see merit in moves to make the VAT a purer consumption tax if the change clearly delivers the largest benefits to higher income persons.
12.4 Enterprises and Investments While the individuals owning directly or indirectly (via interests in an entity) an enterprise may be capable of final consumption, the tax base for a model VAT, the enterprise itself clearly is not. Subject to anti-avoidance arrangements that apply where the enterprise provides in-kind benefits to direct owners, shareholders or employees, a model VAT system would allow enterprises to recover all input taxes associated with its operations, including the acquisition or holding of investments or issue of equity or debt. For the most part, operational VATs achieve the tax relief goal in respect of acquisitions related to ongoing business operations through the input tax credit mechanism. Provided the person acquiring the investments is registered and can show that the acquisition is for a creditable purpose, input tax credits can remove any VAT burden from the acquisition. The system has proved problematic when
2
See, for example, Department of Finance, Canada (2016, p. 24); U.S. Department of the Treasury, Office of Tax Analysis (2015, p. 18).
applied to expenditures incurred in relation to the acquisition or holding of investments, however. Doctrinal interpretations of key VAT principles and technical design features explain the difficulties encountered in applying the input tax credit regime to acquisitions related to investments. Three factors explain why traditionally input tax incurred by registered enterprises on expenditures ancillary to investments did not give rise to input tax credits. The first is the requirement in VAT laws that acquisitions be related to the activities of a business to be creditable acquisitions, along with the doctrinal interpretation of a business as an operating concern carrying on activities. Under this view, the acquisition and ownership of investments by itself cannot constitute a business so an entity that has no activities apart from acquiring and holding investments will not be a business and will not be entitled to input tax credits related to its acquisition or holding of investments. The second factor is a related doctrine that applies where an entity carries on business activities in addition to acquiring investments or attracting investment capital. In this case, the investment activities are likely to be seen as separate from the business and consequently treated as out of scope transactions, outside the reach of an enterprise’s interactions with the VAT system. The third factor restricting input tax credits for investments by a firm that applied alongside the two doctrinal interpretation factors was a technical issue. Investments most often take the form of intangible assets that, in virtually all VAT systems, fall within the definition of financial supplies. A business acquiring any intangible investment will thus ultimately be acquiring the assets for the purpose of making a financial supply on the eventual disposal of the investment. As financial supplies are treated as exempt (input taxed) supplies in all VAT systems and VAT systems do not allow input tax credits for acquisitions related to making financial supplies, prima facie no credits would be available in any case in which investments were acquired. The courts have gone some way to addressing the doctrinal restrictions on input tax recovery and the technical impediment to claiming credits. Initially, the European Court of Justice in particular took a narrow view of business activities or enterprise, denying input tax credits to pure investment vehicles such as holding companies.3 Perhaps realizing its rigid stance yielded tax burdens where there clearly were only economic arrangements with no final consumption, the Court later retreated from the hardline position it had originally adopted, distinguishing its first precedents and extending input tax credits to holding companies provided they also supplied at least some limited services to the companies below.4 Initially, the same Court was more generous in terms of capital raising by companies, treating the 3 See, for example, ECJ, 20 June 1991, Case C-60/90, Polysar Investments Netherlands v. Inspecteur der Invoerrechten en Accijnzen, EU:C:1991:268; ECJ, 14 November 2000, Case C142/99, Floridienne S.A. and Berinvest S.A. v. Belgian State, EU:C:2000:623; ECJ, 6 February 1997, Case C-80/95, Harnas and Helm CV v. Staatssecretaris, EU:C:1997:56. 4 See, for example, ECJ, 27 September 2001, Case C-16/00, Cibo Participations S.A. v. Directeur régional des impôts du Nord-Pas-de-Calais, EU:C:2001:495.
issuance of shares as part of an enterprise’s economic activities,5 but a later retreat saw the Court take some types of capital raisings outside the scope of the enterprise.6 Expenses incurred by owners of a business to resolve operational or management disputes with other owners may also give rise to non-recoverable input tax if the resolution of the problems ultimately takes the form of a buy-out of the other owners. For example, a holding company incurring legal expenses to solve disputes with other owners could find the expenses are attributed to the acquisition of a financial supply if the end result is the acquisition of shares from the co-owners.7 While judicial interpretations can open the door to some relief from overtaxation by treating some acquisitions as creditable acquisitions, the general effect of traditional interpretations of a business is to deny enterprises input tax credits for expenditures related to the acquisition of investments or creation and sale of financial instruments including bonds and shares. A comprehensive solution to the problem would require either a statutory widening of the business concept or an expansion of the definition of creditable acquisitions. An example of a partial solution based on this approach may be found in the Canadian GST legislation which deems a holding company’s inputs related to holding shares or debt in a subsidiary operating company to be incurred for commercial purposes, provided the operating company uses its property for business operations.8 The measure extends to expenses related to the acquisition of shares in a full takeover arrangement.9 While the Canadian statutory response addresses many of the problems arising from judicial interpretations of what constitutes a business activity, particularly the holding company and takeover situations that feature in many litigated VAT assessments, it does not cover all situations. Other situations may be covered by broad grouping rules that consolidate intra-group supplies and acquisitions, including intra-group financial supplies and acquisitions.10 Even taken in their entirety, however, the measures adopted in selected VAT jurisdictions provide only partial relief. Short-term investments, long-term strategic holdings, the acquisition, holding and sale of minority interests in companies, and a host of other transactions that fall outside the narrow parameters of the judicial doctrine exceptions or limited statutory exceptions remain overtaxed. Unlike the case of individuals bearing input tax on investments and savings, there are few technical impediments to providing relief to entities carrying on an 5
See, for example, ECJ, 25 May 2005, Case C-465/03, Kretztechnik AG v. Finanzamt Linz, EU: C:2005:320. 6 See, for example, ECJ, 13 March 2008, Case C-437/06, Securenta Göttinger Immobilienanlagen und Vermögens-management AG v. Finanzamt Göttingen, EU:C:2008:166. 7 See, for example, Andrei 95 Holdings Ltd v. R. [2015] G.S.T.C. 125. 8 Excise Tax Act (Can.), s. 186(1). See further Canada Revenue Agency, GST/HST Memorandum 8.6: Input Tax Credits for Holding Corporations and Corporate Takeovers (November 2011). 9 Excise Tax Act (Can.), s. 186(2). 10 An example is Australia, A New Tax System (Goods and Services Tax) Act 1999 (Cth.), Div. 48.
enterprise or business. The existing registration system already caters for these persons and input tax credits can be provided by way of specific targeted measures as in the Canadian example or modifications to broader definitions of business or creditable acquisitions. Nor is the political economy concern over public perception of reforms that relieve higher income persons from tax as serious an issue. The revenue cost of reform may remain a concern but this may be offset in part by the probable economic benefits as enterprises are freed to operate through economically efficient structures, invest, and attract capital in ways that are not constrained by VAT considerations. A more difficult to resolve issue is that of individuals holding their investments via private holding companies, a logical structure in any jurisdiction where company income tax rates are lower than the top individual income tax rates. Arbitrage opportunities arise if input tax relief is available to registered entities including holding companies but is not provided to individual investors in response to concerns over exacerbating the regressivity of the VAT by removing consumption tax now imposed via input tax on savings. A compromise solution would be to limit recovery of input tax credits to VAT incurred on acquisitions related to non-portfolio investments. This would limit input tax recovery to cases where the investor is using an entity as a vehicle to conduct the business activities.
12.5 Establishing a Benchmark However strong the theoretical case for removing VAT on investments and savings, the prospects for immediate reform are limited. Technical issues, political constraints and fiscal concerns discourage serious consideration of reform in respect of individuals. The first two issues do not arise in the case of registered enterprises and the Canadian experience shows that short-term fiscal fallout from legislative reform to allow input tax credits for some investment activities of enterprises is manageable. However, more pressing reform issues in VAT jurisdictions—addressing problems of cross-border supplies, fraud, exploitation of concessions, and others— are likely to sideline reform of the VAT treatment of financial investments for the foreseeable future. It is nevertheless important to continue discussion of VAT and financial investments for two reasons. First, discussions of the taxation of VAT and financial supplies all too often tends to focus on one aspect of financial supplies, loan intermediary services. Vigilance is needed to ensure the other two types of financial supplies, intangible investments and pooling services, receive equal attention and are incorporated into reform discussions. Second, it is important to establish and maintain and regularly re-evaluate the optimal model VAT treatment of these supplies so there is a benchmark against which current laws and any proposed reforms can be evaluated.
Acknowledgement The author is grateful to Joachim Englisch for important ideas that greatly helped with the development of this chapter.
References Department of Finance, Canada, Report on Federal Tax Expenditures: Concepts, Estimates and Evaluations 2016 (Ottawa, 2016) Simons, Henry, Personal Income Taxation (University of Chicago Press, Chicago, 1938) U.S. Department of the Treasury, Office of Tax Analysis, Tax Expenditures 2017 (Washington, D.C., 2015)
